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July 15, 2010

In Financial Reform Bill, Marketplace Winners and Losers

Money-center banks expected to adapt quickly and pass on bill's costs to customers

Early market reaction to the financial services reform bill, which the Senate passed, 60-39, on Thursday, July 15, was one of relief that the political wrangling is over at last, and banks and companies could now get down to the business of figuring out how the bill's details would affect them and how they could comply while earning profits.

The bill seemed to favor big banks like Citigroup, led by Vikram Pandit, although JPMorgan Chase & Co., led by the seemingly bullet-proof Jamie Dimon, was seen as taking a hit because of its giant consumer base. But smaller community banks, too, are expected to benefit from exemptions on certain provisions and escape relatively unscathed. Either way, finance experts agreed that the worst is over and that markets have already priced in the bill's passage.

Kevin Fitzsimmons, an equity analyst with New York-based Sandler O'Neill + Partners, noted that bank stocks rallied on June 25 when the bill won approval in the congressional conference committee. "This has been looming over the group for the best part of the last few months. For whatever concern there was, banks are getting this behind them," Fitzsimmons said.

In an analysis by large-cap banks titled "Dodd-Frank Act - Could've Been Worse," Barclays Capital took a positive view of the sector, saying the largest banks--including Citigroup, Bank of America, JPMorgan, Wells Fargo, and USB--have the best value despite being the most affected by the reform bill. But, Barclays analysts warned, U.S. banks may lose as much as $17.6 billion in 2013 profits.

"We believe the valuations of the larger banks, generally speaking, are attractive," Barclays stated in its June 28 note. "This is supported by our economists' views of 3.6% GDP growth this year and 3.5% next, with unemployment falling below 8% by the end of 2011."

JPMorgan, Morgan Stanley to Take Biggest Hit

At Goldman Sachs, analysts said the new financial regulations will hit JPMorgan and Morgan Stanley the hardest, and they anticipate a drop in earnings at both banks.

"We believe that passage of this bill represents an important milestone that will go some way to alleviating the uncertainty that has been weighting on the sector," the Goldman analysts wrote. "We now forecast that the large banks could see a 13% hit to normalized earnings."

Analysts expect the bill to have a negative impact on the banking industry's earnings through higher costs and new restrictions, in addition to tying up capital and causing unintended consequences. Still, they say, both derivative reform and the Volcker Rule that restricts banks' involvement in proprietary trading and hedge funds were eased in the final bill, and will hurt only the largest banks.

"Some of the specific provisions came in either as expected or watered down from what some might have feared," Fitzsimmons said. "At first glance it seems like more regulation, which tends not to be a positive development for the banks. It increases their costs, but all that said, it appears to be manageable."

Customers Will Pay Bill's Costs

In fact, banks will most likely work out ways to pass the bill's cost on to its customers.

"Just about every analyst in America who follows banks has put out a report indicating what the cost of different elements of the bill would be. But what's missing in all this analysis is the ability of banks to generate new revenue streams to offset the ones that are being lost," said Richard Bove, a high-profile U.S. banking analyst who recently joined institutional brokerage house Rochdale Securities in Stamford, Connecticut.

Similar to the recent passage of the credit card law, Bove said, customers will likely start receiving letters telling them their banking fees are going up.

"I think once this bill is passed that everyone with a bank account will get a letter saying the cost of that account is now $10 to $15 a month, and if they want to keep their bank account, they either have to come up with the money or they have to increase their balances in the bank," Bove said.

Neil Hennessy, president and portfolio manager of San Francisco-based Hennessy Funds, said that while banks will have to pay more to operate, the only thing holding them back from investing in the economy is uncertainty. U.S. corporations including financial institutions are sitting on about $3.5 trillion in cash right now, he said, "because we don't know what the rules are" and the government keeps introducing new programs and regulations.

At the end of the day, though, businesses and the markets are already in the process of adjusting to the new reality, Hennessy said.

"Typically, it's going to cost a lot more money for banks and financial institutions to operate, which will affect earnings per share, but at some point businesses in the financial industry will pass it on to the individual and everything will be right in wonderland again," he said. "Businesses will figure it out. We just need to know what the costs are. Pass the bill, bring it to us, and we'll look through it and figure out how to make money. We always do."

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